Interest rates strongly influence the currency exchange market. They encourage international investors to invest their money in the forex exchange, in foreign currencies, in order to obtain a high yield. For many years, interest rate differentials between countries have been of significant interest to professional traders. However, most individual traders do not realize that the most important thing here is not the absolute value of each interest rates, but the expectations of future rates.
An understanding of the purpose and the operating methods of a central bank allows a forex trader to get a head start in predicting a probable forex trend or a currency pair trend. For many central banks, inflation is a priority. If inflation (usually measured by the Consumer Price Index) is above the central bank's target, the forex trader can expect to see tighter monetary policy. Similarly, if keeping inflation under control is not the goal, the central bank will seek to ease its monetary policy. By combining the relative monetary policies of two central banks, a trader can then predict the trend of a currency pair. If a central bank raises its interest rates, while another one maintains its rates, the currency whose rate increases is likely to appreciate against the other currency (barring unforeseen circumstances).
For example, in 2006 the euro broke its trading range and it appreciated against the British pound. With consumer prices above the ECB's target of 2%, the ECB has clearly sought to increase its rates several times. In England, inflation was slightly below the ECB's target. The economy didn't allow it to change its interest rate, however, because it was just beginning to show signs of recovery. In fact, during the first three months of 2006, the ECB was especially in favor of reducing interest rates. This led to high volatility of the EUR/GBP pair.
Structure: The U.S. Federal Reserve is probably the most influential central bank in the world. 90% of transactions in the currency exchange market are done using the U.S. dollar, so the Fed's decisions therefore have an effect on the valuation of many currencies. The Federal Open Market Committee (FOMC), which consists of seven Federal Reserve governors and five presidents from the twelve Federal Reserve districts, sets the interest rates within the Fed.
Objective: Long term price stability and sustainable growth.
Frequency of the meetings: Eight times a year.
Structure: The European Central Bank was established in 1999. The ECB's board decides which monetary policy changes will be made. The board consists of the six members of the ECB's executive board and the national central bank governors of the euro zone's 17 countries. As a central bank, the ECB does not like surprises. Therefore, whenever it plans to change its interest rate, it warns the market through press releases.
Objective: Price stability and sustainable growth. Nevertheless, unlike the Fed, the ECB strives to maintain the annual increase in consumer prices below 2%. Europe's economy depends on its exports, so the ECB tries to contain the strength of its currency in order to limit the foreign exchange risks associated with exports.
Frequency of the meetings: Twice a week, but the monetary policy decisions are generally taken during meetings which are followed by a press conference (11 times a year).
Structure: The Bank of England's monetary policy committee has 9 members: 1 governor, 2 deputy governors, 2 executive directors and 4 external experts. The BoE, under the leadership of Mervyn King, is widely regarded as being the most effective central bank.
Objective: To maintain stable prices and confidence in the currency. To achieve this, the central bank has an inflation target of 2%. If prices break this level, the central bank will seek to curb inflation, while a level below 2% will prompt the central bank to take steps to stimulate inflation.
Frequency of the meetings: Monthly.
Structure: The Bank of Japan's monetary policy committee consists of the BoJ's governor, 2 deputy governors and 6 other members. Japan is highly dependent on its export activities, the BoJ therefore has a greater interest than the ECB does in terms of preventing its currency from becoming too strong. The BoJ has a reputation for artificially weakening its currency by selling it in exchange for the U.S. dollar or the euro.
Objective: To maintain price stability and ensure the stability of the financial system, inflation is the BoJ's primary concern.
Frequency of the meetings: Once or twice a month.
Structure: The Swiss National Bank's committee consists of three individuals. Unlike most other central banks, the SNB establishes an interest rate range rather than a specific target. As with Japan and the euro zone, Switzerland is also dependent on exports, which means that the SNB also has an interest in keeping its currency from becoming too strong. Therefore, its general bias leads it to be more conservative with its interest rate increases.
Objective: To ensure price stability while taking into account the economic situation.
Frequency of the meetings: Quarterly.
Structure: The monetary policy decisions made at the Central Bank of Canada are made by the Board of Governors, which consists of the Bank of Canada's governor, the senior deputy governor, 4 deputy governors and 12 administrators appointed by the government.
Objective: To maintain the integrity and the value of their currency. The central bank has an inflation target of 1-3%. It has managed to keep inflation within this range since 1998.
Frequency of the meetings: 8 times a year.
Structure: The Bank of Australia's monetary policy committee consists of the central bank's governor, its deputy governor, the secretary of the treasury and 6 independent members appointed by the government.
Objective: To ensure the stability of the currency as well as maintain full employment, economic prosperity and the welfare of the Australian people. The central bank has an inflation target of 2-3% per year.
Frequency of the meetings: 11 times a year, usually on the first Tuesday of each month (except in January).
Structure: Unlike other central banks, the decision-making power in terms of monetary policy ultimately rests on the central bank's governor.
Objective: To maintain price stability and avoid instability in terms of production, interest rates and exchange rates. The RBNZ has an inflation target of 1.5%, if this goal is not reached, the governor of the RBNZ may eventually be fired.
Frequency of the meetings: 8 times a year.
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